Arnold Kling

The Too-Little-Inflation Trap

Arnold Kling, Great Questions of Economics
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Brad DeLong discusses a form of the Liquidity Trap (look for 2002-03-26), in which the monetary authority becomes hamstrung by the inability to drive the short-term interest rate below zero.

Suppose, for example, that the Federal Reserve sets the Federal Funds rate at 3% per year, and that there is a term premium of 3%, a risk and default premium of 3%, and an inflation rate of 2%. Then the real interest rate that matters for business investment is 7%--3% plus 3% plus 3% minus 2%. Now suppose that the Federal Reserve staff appear, and say that their studies suggest that full employment requires a real interest rate of 3%. Then--with an inflation rate of 2%--the Federal Reserve is out of luck: It cannot drive the nominal interest rate on Federal Funds below zero, and so it cannot drive the real interest rate relevant for businesses below 4%--3% plus 3% minus 2%.

Supply-side economists want the Fed to set a target for inflation of zero, but without risking deflation. What DeLong is saying is that this may be impossible, because at zero inflation you are likely to fall into the liquidity trap, at which point deflation indeed is a risk. Therefore, he argues, it is safer to set a target for inflation that is somewhere above zero (he suggests 4 percent).

DeLong quotes from Federal Reserve meeting minutes that in the liquidity trap there are "unconventional policies" that might be tried. For example, the Fed could buy long-term bonds.

Discussion Question. What other "unconventional policies" might be tried in a liquidity trap?

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